Seven Questions to Ask Before Buying Your First Real Estate Investment Property
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Getting started in real estate investing isn’t easy, but with an outline to guide new investors, the process will be far less overwhelming. Answering these seven questions can help provide a good foundation for finding and acquiring the right real estate investment property.
- What are my goals?
- What strategy makes sense for my goals?
- Does this property match my buy box?
- How will I finance my investment?
- Is there a good return on investment?
- Do I have time to self-manage the property?
- What kind of closing company will I choose?
There are many strategies savvy investors leverage to build their portfolios, but without a clear goal, they’ll fall flat. Many people turn to real estate investing for specific reasons like the following:
- Retirement funding
- Saving for a child’s college education
- Increasing monthly incomes
- Insulating wealth from the volatility of the stock market
In a LinkedIn poll, we asked what motivates our followers to invest in real estate. The most popular response was creating security for their families, followed by financial freedom now, and a tie between the ability to leverage the equity and better returns and tax incentives than other asset classes.
The underlying motivations for investing in real estate can be broadly divided into three categories:
- Cashflow optimization for financial freedom now.
- Portfolio building to leverage equity and create financial security for family members.
- Wealth protection to diversify portfolios and reap the better returns and tax incentives associated with real estate assets.
While it’s important to have a long-term goal, not every strategy to reach it will be relevant to every investor’s current financial situation. When setting a real estate investment goal, take stock of your resources, time, and network. It takes time to build a portfolio, so it won’t make sense to turn to real estate investing strategies designed for a more established investor when starting out.
Setting a goal and finding a strategy to match it may feel overwhelming and even out of reach without access to capital.
Fortunately, there are ways to get started in real estate investing with little or no money. Wholesaling is one strategy that doesn’t require tons of upfront cash. Real estate investment trusts (REITs) and house hacking are other excellent real estate investment strategies on a budget.
Other popular and more advanced strategies include buy, rehab, rent, refinance, repeat (BRRRR), property tax lien investing, fix-and-flip, short-term buy and hold rentals, and long-term buy and hold rentals. These and other more advanced strategies typically require a strong understanding of the market and the appropriate financing options to produce successful results.
There may be overlap between the investment goals and the strategies used, but here are several examples of how an investor might match business and financing strategies to their long-term investment goals.
Long-term Investment Goal
Examples of Strategies
Cash Flow Optimization
These strategies are known to help generate cash quickly for new investors but may come with higher risks.
Hard money loans
These strategies help build and maintain a real estate portfolio by leveraging the equity and cash flow of current assets.
|BRRRR method |
Rental debt snowball
All-cash rental plan
These are advanced strategies that preserve current capital while building future wealth and may require the help of tax or legal professionals.
Once an investor has aligned a realistic goal with a relevant strategy, the next step is to find a property that matches it.
Does this property match my buy box?
The buy box is the list of criteria that an investor prioritizes when researching and purchasing a property. Characteristics like:
- Property type (multi-family, single-family, land, etc.)
- Square footage and number of bedrooms
- School districts
Depending on the strategy, one or more of these characteristics may move toward the top of the list. For instance, if a new investor plans to try a buy-and-hold house hacking strategy funded by a 203k loan, a duplex, triplex, or quadplex is a must. For house flippers planning to sell to a family, other considerations like the number of rooms, school district, and amenities like parks and pools will become more critical.
This is where knowing the market and working with professionals familiar with the area can help make or break your real estate deals.
How will I finance my investment?
There are several ways to finance a real estate investment. A few of them include:
- Fix-and-flip loan: also called bridge loans, this financing option helps bridge the gap between acquisition costs and repair costs to increase the value of the property and final sales price.
- FHA 203(k) loan: an option ideal for first-time investors with a little money for a downpayment looking for a duplex or multi-family property up to four units to renovate. Investors must be willing to live in the property for at least one year.
- Conventional mortgage: a traditional source of financing that usually requires good credit and higher down payment.
- Private money lenders: allows investors with a network to access the capital from personal connections.
- Hard money lenders: an option for investors who may not have stellar credit, but the trade-off is usually higher rates.
- Self-directed IRA account: like a 401k, an Individual Retirement Account is a savings account that grows over time with compounding, tax-free incentives. A self-directed IRA can be used to purchase all sorts of assets, including real estate.
- Cash financing: investors avoid interest and increase cash flow if they can access the upfront capital.
A lending professional, like a mortgage broker, may help investors better understand what options are available and how each could benefit a particular goal.
Is there a good return on investment?
Calculating the return on a real estate investment depends on the intended use. For flippers looking to realize the return on investment (ROI) as soon as possible, there two main types of calculations used:
- The Cost Method
- The Out-of-Pocket Method
The Cost Method
The cost method is a straightforward formula dividing the equity by the combined cost to acquire and repair a property. The ROI is expressed as a percentage.
For example, if the property costs $70,000 to purchase and $30,000 to repair, the total costs come to $100,000. If the property is sold for $150,000, the investor’s equity is $50,000.
Dividing $50,000 by $100,000 = 50% ROI.
All-cash deals would use the cost method to calculate ROI.
The Out-of-Pocket Method
The out-of-pocket method is more commonly used for financed transactions, resulting in a higher ROI.
For instance, if an investor purchases a property for $70,000 with a down payment of $20,000 and puts in $30,000 for repairs, the total out-of-pocket expenses are $50,000. If the property is valued at $150,000, the new equity amounts to $100,000. That’s an ROI of 66% or $100,000 divided by $150,000.
Of course, with financed deals, the closing costs to originate the loan increases the initial upfront costs compared to an all-cash transaction. Other factors can affect the final ROI, like the interest rate, taxes, and other carrying costs, if the property doesn’t sell as quickly as expected.
Calculating ROI on Rental Properties
A buy-and-hold strategy introduces another dimension of ROI calculations taking into account the cost to operate and maintain the property and the equity growth. While the ROI is realized more slowly compared to house flipping, the steady cash flow income and potential long-term equity growth make long-term and short-term rental strategies attractive.
If a loan was taken out to finance the purchase of the property, ongoing mortgage payments must be subtracted from the monthly rent. Once the total annual rent income is calculated, it’s divided by the original out-of-pocket expenses like the down payment, closing costs, and any repairs.
The two-part equation looks like this:
- Rental Income – (Mortgage Payment + Operating Costs) = Annual Return
- Annual Return ÷ Out-of-Pocket Expenses = ROI
If you want to add equity growth into the equation, it can be added to the annual return after examining the mortgage amortization schedule to find out how much of the mortgage payments went toward the principal of the loan.
Benchmarking ROI for Real Estate
Every real estate investor will have a different idea of what threshold is required for a “good” return. Historically, S&P 500 stocks average annual returns of 10% since 1926. While home-flipping is seeing a downward trend in returns compared to previous years, the ROI in 2020 ranged between 19.7% and 92.5%. The most successful flippers were in the Scranton, PA area. The worst returns were in Idaho. Regional differences in inventory, homebuyer or renter demand, design tastes, and other factors can impact the bottom line, so understanding the market and competition is vital to predicting a realistic ROI.
Do I have time to self-manage the property?
For investors who want to prioritize cash flow, self-managing a long-term or short-term property might sound like a great way to reduce monthly operating costs and increase revenue. However, it takes a lot of time and additional skills to manage a property. Self-management requires calculating a fair market rent, marketing the property, maintenance, rent collection, and bookkeeping.
If it all seems like too much, outsourcing the work to a property manager or company might make sense depending on overall costs.
What kind of closing company will I choose?
The title and closing process is an often overlooked aspect of real estate investing. Of course, every investor wants to close on a property as quickly and as efficiently as possible while saving on closing costs. Still, not all title agencies are equipped to do the type of closings common among investors. An investor-focused title platform like Blueprint can accommodate more complex transactions like double closes and assignment contracts. We also focus on reducing friction points in communication by providing all parties with a dashboard to track transaction milestones and manage tasks. Blueprint customers save time at closing by electronically signing documents beforehand and scheduling remote online notarizations or mobile signings whenever state laws or underwriting guidelines permit.
In addition to saving you time, we’re finding unique approaches to reducing title costs. Partnering with our affiliated underwriter, Southwest Land Title Insurance Company, allows Blueprint to deliver policies with up to 40% lower premiums in some states.
Learn more about how Blueprint can help you with upcoming closings; schedule a demo today.